The Financial Crisis II. Is Peter Wallison Credible?

 

“It was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.
 
                                                             former Congressman Barney Frank, 2010

“The ferocity of the left in defending Fannie Mae, Freddie Mac, and the government’s housing policies before 2008 is sometimes shocking, especially when even Barney Frank has given up.  It makes you wonder why this is so important to them.  They have no data, no policy arguments, just a virulent denial that anything other than the private financial sector could possibly be responsible for the financial crisis.”
                                                  “Hidden in Plain Sight,” p 42, by Peter Wallison, 2015

My last post, “The Financial Crisis I. The Cause” reported on a new book “Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again” by Peter Wallison, a financial policy analyst at the American Enterprise Institute.  He makes a very strong case, with voluminous documentation, that the basic cause of the financial crisis was the HUD policy requiring government agencies like Fannie Mae, Freddie Mac and the FHA to gradually acquire an increasing percentage of subprime mortgages.  When the housing bubble finally burst in 2007, the enormous number of delinquencies and defaults among these nontraditional mortgages, aggregate value over $5 trillion, drove down housing prices and caused the financial crisis.
CaptureAs noted above by Mr. Wallison himself, such an explanation is simply unacceptable to people who insist on blaming the private sector for the crisis.  Rather than dealing with public records and data available, they instead try to discredit Mr. Wallison.  My purpose today is to give two vivid examples of the types of documents which Mr. Wallison uses to make his case:

  • (Fannie Mae 10-K report, 2006). “We have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet HUD’s increased hosing goals and new subgoals.  These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions.  We have also relaxed some of our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products that are more likely to serve the borrowers targeted by HUD’s goals and subgoals, which could increase our credit losses.
  • (statement by Daniel Mudd, former Fannie Mae CEO, April 2010). “Fannie Mae’s mission regulator, HUD, imposed ever-higher housing goals that were very difficult to meet during my tenure as CEO.  The HUD goals greatly impacted Fannie Mae’s business, as a great deal of time, resources, energy and personnel were dedicated to finding ways to meet these goals.  HUD increased the goals aggressively over time to the point where they exceeded the 50% mark, requiring Fannie Mae to place greater emphasis on purchasing loans in underserved areas.  This became particularly problematic when goal requirements grew to far exceed the proportion of eligible mortgages originated in the primary market.”

Mr. Wallison’s book is filled with this type of detailed documentation for the case he is making.  It should be persuasive to anyone with an open mind.  It certainly is to me.  Now that Mr. Wallison’s credibility is established, it is time to discuss the implications of his thesis.  Stay tuned!

The Financial Crisis I. The Cause

 

Only by understanding the factors that led to and amplified the crisis can we hope to guard against a repetition.                                                                                                         Ben Bernanke, September 2, 2010

An outstanding new book by Peter Wallison, ”Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again” gives a voluminous and highly compelling explanation of the main cause of the financial crisis of 2008.  Mr. Wallison worked at the Treasury Department in the 1980s, was a member of the Financial Crisis Inquiry Commission (2009 – 2011) and is currently a scholar at the American Enterprise Institute.
CaptureHere is the outline of Mr. Wallison’s story:

  • The Department of Housing and Urban Development gradually increased the requirement that loans acquired by Fannie Mae and Freddie Mac be made to low- and moderate-income borrowers from 30% in 1992 to 56% in 2008.
  • As a result of these policies, by the middle of 2008 there were 31 million Nontraditional (low down payment and/or poor credit) Mortgages (NTMs) in the U.S. Financial system, more than half of all mortgages outstanding, with an aggregate value of more than $5 trillion. At least 76% of these were on the books of government agencies such as Fannie, Freddie and the FHA or banks and S&L institutions, holding loans which they were required to make by the Community Reinvestment Act.
  • The 24 million NTMs acquired or guaranteed by government agencies were major contributors to the growth of the housing bubble and its lengthy extension in time.
  • The growth of the bubble suppressed the losses that would ordinarily have brought NTM type Private Mortgage-Backed Securities (PMBS) to a halt but rather made these instruments look like good investments.
  • When the bubble finally burst, the unprecedented number of delinquencies and defaults among NTMs drove down housing prices.
  • Falling home prices produced losses on mortgages, whether they were government backed or PMBS.
  • Losses on mortgages caused investors to flee the PMBS market, reducing the liquidity of the financial institutions that held the PMBS.
  • Once the housing bubble burst, four major errors were made by our top government financial officials: The first and major error was the rescue of Bear Stearns. The moral hazard created by this action reduced the incentive for other firms to restore their capital positions. Once Bear had been rescued it was essential to rescue Lehman Brothers. Treasury Secretary Paulson and Fed Chairman Bernanke’s arguing that they did not have legal authority to rescue Lehman provided an excuse for Congress to pass the destructive Dodd-Frank Act. Finally, TARP accomplished little but caused much popular resentment against the banks which supposedly got bailed out.

Conclusion: as long as the American people don’t understand that government housing policies were the main cause of the financial crisis, we are likely to repeat the same mistakes over again.